Professor Paul Gillis has done a great job of analyzing issues related to China and accounting practices in his “China Accounting Blog.” In particular, I recommend reading his entries entitled “Audit scandals in China” and “China and the PCAOB” (the PCAOB has not inspected any of the 59 Chinese audit firms registered with it).

As the Professor notes, many privately-owned Chinese companies have gone to US stock markets to raise capital over the past few years – companies that found it difficult to get regulatory approval to list on Chinese stock exchanges. Many of the US listings were accomplished using the “backdoor” method of a reverse merger, where a Chinese company merges into a publicly listed shell – a practice that has drawn the SEC’s attention according to this article.

At a recent New York Bar Association conference, the Chief Accountant of the SEC’s Division of Corporation Finance, Wayne Carnall, warned against over-reliance on the so-called ABA-auditor “treaty” in reporting litigation contingencies on financial statements.

The “treaty,” which has been in place for roughly 35 years, seeks to preserve attorney-client confidences by providing a structure for dialogue between auditors and corporate counsel regarding financial statement presentation of information on pending and potential litigation. It provides the template for the “auditor inquiry letters” directed to both inside and outside counsel, and cautions corporate counsel (both inside and outside) against providing certain kinds of information to outside auditors.

One important feature of the treaty cautions counsel against providing to auditors estimates about the amount or range of potential loss from a litigation unless the lawyer believes that the probability of inaccuracy is “slight.”

A problem is that Generally Accepted Accounting Principles (“GAAP”), and in particular ASC 450 (formerly FAS 5), call upon those preparing financial statements to evaluate whether a loss from litigation is “probable,” whether the amount of loss can be “reasonably estimated,” and, where the loss is both probable and can be reasonably estimated, to accrue an appropriate amount. Where accrual is not required, but a loss is nonetheless “reasonably possible,” the financial statements are to include “an estimate of the possible loss or range of loss or a statement that such an estimate cannot be made.”

At the bar association conference, Chief Accountant Wayne Carnall, in responding to questions, warned that reliance on the treaty would not justify nonfulfillment of ASC 450’s requirements. He observed that the treaty is “not part of the accounting codification” and that the requirements of GAAP must control. He also warned that “companies have an obligation to comply with GAAP and compliance with the ‘treaty’ is not a defense.” The Chief Accountant has elsewhere made clear that litigation contingency reporting will be under a microscope this financial reporting season. Given the historical prominence of the ABA treaty in lawyer-auditor dialogue, companies may want to make sure that the litigation reporting requirements of ASC 450 are being fulfilled.

Webcast: “The SEC Staff on International Issues”

Tune in tomorrow for the webcast – “The SEC Staff on International Issues” – to hear the Chief of the Corp Fin’s Office of International Corporate Finance Paul Dudek – as well as former Senior Staffers Alex Cohen of Latham & Watkins and Sara Hanks – discuss the latest rulemakings and interpretations from the SEC that relate to non-US companies.

Old-Timers Trivia Question: There have been three heads of OICF over time. Paul and Sara are the latest – who was the first? Drop me a line if you know the answer…